Alternative Minimum Tax

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Alternative Minimum Tax (AMT) is part of the Federal income tax system of the United States. There is an AMT for those who owe personal income tax, and another for corporations owing corporate income tax. Only the AMT for those owing personal income tax is described here.

History and current controversies

The AMT was introduced by the Tax Reform Act of 1969^[1] and became operative in 1970. It was intended to target 155 high-income households that had been eligible for so many tax benefits that they owed little or no income tax under the tax code of the time.^[2] The original AMT targeted tax shelters used by a few high-income households. However, when Ronald Reagan signed the Tax Reform Act of 1986, the AMT was greatly expanded to aim at a different set of deductions that most Americans receive. "A law for untaxed rich investors was refocused on families who own their homes in high tax states."^[3]

The AMT is imposed under 26 U.S.C. § 55 and disallows many deductions and exemptions allowable in computing "regular" tax liability. (Regular tax liability is defined in 26 U.S.C. § 55(c)(1), with reference to 26 U.S.C. § 26(b), and does not include AMT and various other categories of taxes imposed under Chapter 1 of Subtitle A of the Internal Revenue Code.) The AMT sets a minimum tax rate of either 26% or 28% (depending on the amount of the taxpayer's "alternative minimum taxable income," as adjusted) on some taxpayers so that they cannot use certain types of deductions to lower their tax. By contrast, the rate for a corporation is 20%. Affected taxpayers are those who have what are known as "tax preference items". These include long-term capital gains, accelerated depreciation, certain medical expenses, percentage depletion, certain tax-exempt income, certain credits, personal exemptions and the standard deduction.

In recent years, the AMT has been under increased attention. Because the AMT is not indexed to inflation and recent tax cuts,^[4][2] it has bracket creep, meaning that an increasing number of upper-middle-income taxpayers have been finding themselves subject to this tax. In 2006, the IRS's National Taxpayer Advocate's report highlighted the AMT as the single most serious problem with the tax code. The advocate noted that the AMT punishes taxpayers for having children or living in a high-tax state and that the complexity of the AMT leads to most taxpayers who owe AMT not realizing it until preparing their returns or being notified by the IRS. ^[5]

A brief issued by the Congressional Budget Office (CBO) (No. 4, April 15, 2004), concludes:

"Over the coming decade, a growing number of taxpayers will become liable for the AMT. In 2010, if nothing is changed, one in five taxpayers will have AMT liability and nearly every married taxpayer with income between $100,000 and $500,000 will owe the alternative tax. Rather than affecting only high-income taxpayers who would otherwise pay no tax, the AMT has extended its reach to many upper-middle-income households. As an increasing number of taxpayers incur the AMT, pressures to reduce or eliminate the tax are likely to grow."^[6]

However, CBO's rules^[7] state that it must use current law in its analysis, and at the time the above text was written, the AMT threshold was set to expire in 2006 and be reset to far lower values.^[8]

For years, Congress has passed one-year patches aimed at minimizing the impact of the tax. For the 2007 tax year, a patch was passed on 12/20/2007, but only after the IRS had already designed its forms for 2007. The IRS had to reprogram its forms to accommodate the law change.

Structure

Example of level of TMT (in absolute and relative terms on top and bottom) in 2000 and 2004 (orange and blue respectively) for a married couple who are filing jointly. The dashed line on the top show the narrow margin between the TMT and current 2004 tax rate, which means that not many deductions are needed before the AMT must be paid. The TMT is the minimum amount of tax a person will end up paying, if it is less than the usual tax, there is no AMT. If it is more than the usual tax, the AMT makes up the difference.

AMT Taxable Income (AMTI)

In addition to the normal tax code calculations, the AMT system uses a different set of rules for determining taxable income and allowable deductions. The "tax preference items" are added back, then an AMT Exemption is subtracted to compute AMT Taxable Income (AMTI). The AMT Exemption is phased out at 25 cents per dollar of AMTI above $150,000 on joint returns. Criticism often focuses on the fact that the $150,000 phase-out threshold has never been adjusted for inflation since its enactment in 1986. AMT Exemption has been changed by a series of short-term legislative "patches" over the years, as shown in the table below. The most recent "patch" was extended through 2008.

Tentative Minimum Tax (TMT)

Applying a 26/28% rate schedule to the AMTI gives the "Tentative Minimum Tax" (TMT). TMT is 26% of AMTI up to $175,000, plus 28% of the rest of the AMTI, if any. The TMT is compared to the income-tax amount calculated for the taxpayer. If the regular income-tax amount is greater than the TMT, no special action is required. If the TMT is greater than the tax calculated using the regular rules, the difference between the TMT and the regular tax is added to the regular tax amount, so the taxpayer pays the full amount of the TMT, although some of that tax is considered regular tax and some is considered AMT.

AMT Exemption Phaseout and Effective Marginal Rates

For 2007, the AMT Exemption is not fully phased out until AMTI surpasses $415,000 for joint returns. Within the $150,000 to $415,000 range, the TMT rates of 26% and 28% are effectively multiplied by 1.25, becoming 32.5% and 35%. The TMT rate for capital gains becomes 21.5% to 22% rather than 15%, because each dollar of capital gain causes 25 cents more of ordinary income to be taxed at 26% or 28%. These are the true marginal federal tax rates for most taxpayers owing AMT. These marginal rates for TMT exceed regular tax rates at the lower end of this income range. Therefore AMT liability (the excess of TMT over regular tax) typically increases as income increases above $150,000. Non-deductibility of state income tax under the TMT exacerbates this problem. Advice to accelerate income when you will be liable for AMT is therefore exactly backwards for most taxpayers.

AMT carry-forward credit

AMT has different rules about carry-forward losses, the carry-forward cost basis, carry-forward tax credits, and carry-forward passive losses.[1] The portion of the tax that is considered AMT may be available in later years as a "Minimum Tax Credit", reducing the regular income tax due in later years, but not below the taxpayer's TMT level in those later years.

Adjusted Current Earnings

Certain items of income, deductions, credits, etc., receive different tax treatment for the Alternative Minimum Tax (AMT) than for the regular tax. Example includes a "running balance" of the excess of the corporation's total increases in AMTI from prior year adjusted current earnings (ACE) adjustments over the total reductions in AMTI from prior year ACE adjustments.

Criticisms

Critics of the AMT argue that it suffers from various flaws. The AMT:

• Like all taxes, the AMT is distortionary. The only non-distortionary taxes are on unimproved value of land and a fixed per-capita "head taxes"^[9]
• Threshold is not indexed for inflation so that over time, the real income threshold declines and the fraction of taxpayers subject to the AMT rises over time. This is known as fiscal drag or bracket creep.
• Taxes realized capital gains on a one year rather than a multiple year basis. For example, if a taxpayer has a tax loss carried forward from a prior year, that loss is not deductible under the AMT.
• Removes the deductibility of state and local taxes.
• Disallows the foreign tax credit, creating unavoidable double taxation for the more than 8 million American citizens living abroad. Some modest income families owe AMT solely because of currency fluctuations.
• Businesses and individuals have to do twice the amount of tax planning when considering whether to sell an asset or start a business. First you should consider whether a particular path of action will increase your regular income tax and then you should calculate if alternative tax will increase.
• Taxes are owed in the year that a purchase of ISO stock options occurs, even if no stock is sold and thus no actual income exists. In extreme cases, if the stock is private or the value drops, it may be impossible to realize the money the AMT demands. ^[10]

Determining whether one is subject to the AMT can be difficult. According to the IRS's taxpayer advocate, determining whether someone owes the AMT can require reading 9 pages of instructions, and completing a 16 line worksheet and a 55 line form.^[11]

Complexity and unintended consequences

The AMT is similar to a flat tax of about 28% on adjusted gross income over $175,000 plus 26% of amounts less than $175,000 minus an exemption depending on filing status after adding back in most deductions ($58,000 if using the standard deduction and married filing jointly). However, taxpayers must also perform all of the paperwork for a regular tax return and then all of the paperwork for Form 6251. Furthermore, affected taxpayers must file AMT versions of all carryforwards since the AMT carryforwards will be different than regular tax carryforwards. Once a taxpayer qualifies for AMT, he or she must file AMT versions of carryforward losses and AMT carryforward credits until they are used up in future years. The definitions of taxable income, deductible expenses, and exemptions differ on Form 6251 from those on Form 1040.

Taxpayer incomes

The AMT's lack of an indexation is widely conceded as a flaw across the political spectrum. In 2005, the Urban-Brookings Tax Policy Center and the Treasury Department estimated that around 15% of households with incomes between $75,000 and $100,000 must pay the AMT, up from only 2-3% in 2000, with the percentage increasing at high incomes. That percentage is set to increase quickly over the coming years if no change is made such as indexing for inflation. Currently, households with incomes below $75,000 are subject to the AMT only very rarely (and thus most tax advisors do not recommend computing AMT for such households). That is set to change in only a few years, however, if the AMT remains unindexed. ^[12]

The median household income in the United States was $44,389 in 2005 , and households making over $75,000 per year made up the top quartile of household incomes. Because those are the households generally required to compute the AMT (though only a fraction currently have to pay), some argue that the AMT still hits only the wealthy or the upper middle class. However, some counties, such as Fairfax County, VA ($100,318), and some cities, such as San Jose, CA ($71,765), have local median incomes that are considerably higher than the national median, and approach or exceed the typical AMT threshold.^{[citation needed]} The cost-of-living index is generally higher in such areas, which leads to families who are "middle class" in that area having to pay the AMT, while in poorer locales with lower costs of living, only the "locally wealthy" pay the AMT. In other words, many who pay the AMT have incomes that would place them among the wealthy when considering the United States as a whole, but who think of themselves as "middle class" because they are not wealthy due to the cost of living in their locale.

The burden of computing the AMT and the disallowance of deductions for state, local, and foreign income taxes magnify criticisms of the AMT, at least in the case of state and local taxes. The deduction for state and local taxes in the normal income tax code can encourage wealthy areas to raise taxes and, in effect, redirect monies that would normally go to the federal government (and hence to residents of poorer states) to their state and local governments, where it can be spent on their own citizens. The AMT removes this incentive for wealthy states to increase their state and local taxes, and makes it more likely that citizens of areas with high costs of living will subsidize citizens of areas with lower costs of living.

The AMT's disallowance of the foreign tax credit has no analogous counter-balancing effect. It continues to disadvantage even low-paid American citizens and green card holders who work abroad or who are otherwise paid in foreign currency. Particularly as the dollar falls around the world, those working abroad see their incomes (when reported to the IRS in terms of US dollars) sky-rocket even if their actual incomes fall from year to year and even if their foreign tax liabilities increase. They are in effect being taxed solely on changes in exchange rates, from which they do not benefit because their household expenses are all in foreign currency.

Avoiding AMT

For many taxpayers, the common question is, "How do I avoid AMT"? The simple answer is to have fewer AMT preferences. The biggest of these are normally state income taxes and local real estate taxes. In any given year, if a taxpayer's Tentative Minimum Tax (TMT) is substantially greater than his or her regular tax, the taxpayer may want to push the last real estate tax payment or state estimated taxes into the upcoming year. Conversely, if the TMT is much lower than the regular tax, prepayment of state and local taxes may help avoid AMT liability in the following year.

The standard deduction is an AMT tax preference. It is zeroed out when computing TMT. If you have an AMT liability when claiming the standard deduction, you should recompute your taxes with whatever itemized deductions you have. Although your AMT liability will decrease, your total tax liability might either increase or decrease. Elect to itemize only if it reduces your total tax, not merely because the AMT component decreases.

Another way to avoid AMT liability is to stay out of the $150,000 to $415,000 income range. For example, it might be better to realize a $1 million capital gain all in one year rather than dividing it into two or three years.

For taxpayers who owe AMT, charitable deductions and home mortgage interest (but not "hard money" refinancing interest!) are especially valuable. They reduce tax liability by the full TMT effective marginal rate of 32.5% or 35% plus the full state income tax marginal rate. This may be quite a bit better than under the regular tax.

Fairmark.com and its AMT discussion forum provide comprehensive practical information on the AMT applicable to even the most complex of situations.

Arguments against repealing the AMT

While many parties agree that the AMT needs to be changed, some argue against its outright repeal.

• The expansion of the AMT was intended by Congress to make the Bush tax cuts more affordable.^[13]
• More than half of the AMT is paid by those with income over $200,000 per year. ^[14]
• The AMT could be amended so as to have little or no effect on those with lower incomes.
• The reduction in tax revenues from repeal is relatively large. The loss is expected to be between $800 billion and $1.5 trillion in federal revenues over 10 years.^[15]. According to the Washington Post, "By 2008, it would cost the Treasury considerably less to repeal the ordinary income tax system than the alternative minimum tax, according to the Tax Policy Center, jointly run by the Brookings Institution and Urban Institute." ^[16]

AMT reform

Policy analysts are divided over the best way to address the criticisms of the AMT. Len Burman and Greg Leiserson of The Tax Policy Center, a joint program of the Urban Institute and Brookings Institution, have proposed a revenue-neutral, highly progressive replacement for the AMT. They suggest an "option [that] would repeal the AMT and replace it with an add-on tax of four percent of adjusted gross income above $100,000 for singles and $200,000 for couples. The thresholds would be indexed for inflation after 2007." This plan, the authors contend, would share the original goal of the AMT—that is, to ensure a certain level of taxation for high earners. ^[17]

Other groups advocate repealing the AMT rather than attempting to reform it. One such group, the Cato Institute, notes that:

• Many tax loopholes the AMT was designed to address have since been closed;
• The AMT is needlessly complex and burdensome to taxpayers;
• A full repeal would leave Federal revenues as a fraction of GDP at about 18%, its average value in recent decades. ^[18]

The National Taxpayers Union also supports repeal. "It is wholly unfair for policymakers to promote certain social and fiscal ideas through exemptions, credits, and deductions, only to take these incentives away when a taxpayer takes advantage of them too well."^[19]

The Tax Foundation says that the AMT could be effectively repealed simply by correcting the deficiencies in the regular tax code. Economist Patrick Fleenor argues that "it is usually the unjustifiable limitations on taxable income…that cause the AMT backstop to kick in. If income were taxed comprehensively by the regular tax code, there would be no way of legally avoiding taxation, and not one taxpayer would have to file the AMT form even if the law were still on the books."^[20]

Notes